Are ETFs Right for You?
ETFs appeal to different types of do-it-yourself investors. Some day-traders like ETFs because of their stock-like qualities and because they can find ETFs that focus on individual sectors or markets. And investors who prefer index funds over actively managed offerings find ETFs appealing because many of them are very cheap. In this ETF Solution, we'll take a closer look at ETFs, their advantages, and disadvantages. While ETFs' low expenses are touted as one of their key benefits, the fact remains that if, like most people, you invest regular sums of money, you'll actually end up costing yourself far more with an ETF than you would with many funds. You pay a brokerage commission each time you buy and sell an ETF, so your costs mount with each trade. Commissions can add up quickly, so if you plan to make periodic investments over time, your overall costs could be lower with an open-end fund. You may have heard about the tax benefits of ETFs, but that is likely because of the significant advantages that ETFs have in the United States. In the UK, ETFs have much less advantage over traditional funds. However, swap-based ETFs (see the solution slide for synthetic versus physical replication) may help avoid the drag of withheld taxes on dividend payments. Dividend withholdings on physical replication ETFs can often be recovered because of the large number of bilateral tax treaties that the UK has signed, although there is an extra hassle of applying for relief. Because ETFs are an effective means of investing in potentially higher-growth foreign countries, investors will often be exposed to currency risk. In certain cases, ETFs are available that attempt to shelter domestic investors from the currency effect of foreign investments by buying foreign exchange swaps to isolate the domestic performance of the investment. However, in many cases investors can use a foreign ETF to diversify their own currency exposure which will likely be biased to their own domestic currency. The ETF universe is flush with options that focus on a single market sector, industry, or geographic region. This means that exchange-traded funds can offer a way to invest in a corner of the market without having to load up on just one or two individual stocks. If you're inclined to invest in more-focused ETFs, it makes sense to be a contrarian, not to chase what's been hot recently. Too often, by the time a hot-performing market segment catches your eye, it's just about to cool down. Unfortunately, some ETF providers have a bad record of launching new ETFs in faddish corners of the market, a practice that tends to encourage investors' worst instincts.
ETFs should have appeal for cost-conscious investors who don't trade frequently. Multiple studies by Morningstar have shown that a fund's expense ratio is a reliable predictor of future success. And because ETFs trade on an exchange, transactions occur directly between investors, meaning ETF providers don't have to manage hundreds of customer accounts or staff call centres--lowering overhead and, by extension, expense ratios. On average, ETFs have a noticeable expense ratio advantage over the typical passive and actively managed funds in many of Morningstar's fund categories.
On the cost front, an ETF will often be the most cost-effective choice for those who use discount brokers, invest a large lump sum of money, and are willing to hold the investment for the long term. For all others, an exchange-traded fund isn't likely to have a big cost advantage over a plain-vanilla, low-cost index fund.
Using ETFs as tools for short-term speculation negates their greatest advantage over other investment vehicles: low costs. If you trade frequently, brokerage commissions can add up fast, thereby eroding the ETF's low-cost advantage. So to benefit from an ETFs' best feature, avoid the quick-trading crowd and adopt a disciplined, long-term mind set instead.
